(a) That to achieve a more robust and durable tax system, taxable income
be calculated on the basis of cash flows and changing tax values of assets and liabilities
-- with increasing and decreasing adjustments to reflect tax policy effects.

Incorporation in tax law

(b) That the cashflow/tax value approach be reflected in the tax law:

(i) with expenditure -- which is not of a private nature and does
not relate to exempt income -- being treated consistently with the accounting approach of
classifying expenditure as attracting immediate write-off, amortisation or capitalisation
according to whether or not it gives rise to an asset recognised as being on hand at the
end of a year;

(ii) with the change in the tax values of all non-private assets and
liabilities, unless specifically excluded or exempted, being reflected in the calculation
of taxable income; and

(iii) with the tax value of assets and liabilities being determined
at the end of the year in accordance with the relevant class of asset or liability.

Revenue-neutral implementation unless expressly varied

(c) That the cashflow/tax value approach be implemented in a
revenue-neutral manner -- except to the extent that other recommendations in this
report expressly propose variations to the existing law.

Fundamental to the reforms of the business tax system recommended by the Review is a
principle-based framework for a reformed income taxation system. The recommended framework
is driven by the need to improve the structural integrity of the present system, to reduce
complexity and uncertainty, to provide a basis for ongoing simplification and to align
more closely taxation law with accounting principles wherever possible.

The existing law is based on legal concepts of income that have evolved over many
years. Central to it are the concepts of ordinary income, statutory income including
capital gains, and expenses and losses of either a `revenue' or `capital' nature.

As a consequence of the evolution of the existing law, assets may be taxed in a variety
of ways depending on the purpose for which they are held. This creates uncertainty and
complexity in the law, of the kind illustrated in the Review's first discussion paper, A
Strong Foundation.

To distinguish expenses consumed in a tax year from expenses that essentially involve a
conversion from one type of asset to another, the existing tax system uses the concept of
capital expenditure. The absence of statutory principles guiding that differentiation has
resulted in uncertainty and led to the mischaracterisation of some expenses.

Whether business expenditures are recognised for income tax purposes and, if
recognised, the timing of their deductibility now depends more on the historical
development of the law than on clearly enunciated principles. In particular, the treatment
of the changing values of different categories of assets and liabilities has been grafted
into the law in an uncoordinated and thus non-comprehensive way.

A range of expenditures -- known as blackhole expenses by tax
practitioners -- either attract no deductions at all or are not deductible in a
manner consistent with their declining value (see A Platform for Consultation,
page 101). The lack of sound principles concerning the recognition of expenditure as
well as assets and liabilities has influenced these outcomes -- as has the ad hoc approach
of adopting a multitude of amortisation regimes to recognise the decline in value of
particular categories of assets. The lack of recognition, together with the
mischaracterisation of some expenses, has led to distortions in the measurement of taxable
income.

The Review is strongly of the view that a more coherent and durable legislative basis
for determining taxable income is essential to reducing uncertainty and complexity in the
present system. That redesigned tax law will underpin a more consistent, transparent and
sustainable tax system. Having a structure which is more enduring and robust, and which
can flexibly accommodate future changes, has much to commend it. Of itself, it will not
imply a broadening of the tax base: variations to the base should occur only by express
intention.

Determination of taxable income under the cashflow/tax value approach involves
recognition of the two components of a taxpayer's income -- the net annual cash flows
from use of relevant assets and liabilities and the change in tax value of those assets
and liabilities (see A Platform for Consultation, pages 27-34).
Recognising the practical constraints in taxing the annual change in value of all assets
and liabilities, the use of tax values ensures that taxpayers will generally continue not
to be taxed on unrealised increases in balance sheet values.

Defining income in a manner structurally consistent with both economic and accounting
approaches to income measurement -- rather than relying on the current mix of
statutory and judicial definitions of assessable income offset by an unstructured and
highly differentiated set of deductions -- supplies the high level unifying principle
that cannot be found anywhere in the current income tax legislation. Application of that
unifying principle will provide structural integrity and durability to the income tax law
that the existing patchwork definitions simply cannot offer, however they might be
amended.

An essential element of income measurement is the deduction of expenses consumed in the
course of deriving gains. A treatment of expenditure which is consistent with the
accounting approach of classifying expenditure by reference to the life of the benefit
acquired is a fundamental feature of the cashflow/tax value approach.

All non-private expenditure, including existing blackhole expenses, will be recognised
in the calculation of taxable income -- unless specifically excluded by the law for
policy reasons. The need to specify exclusions will result in greater certainty for
taxpayers and administrators. As a general rule only individuals will be recognised as
incurring private expenditure.

Where expenditure gives rise to an asset, and that asset is recognised for tax purposes
at the end of a year, its tax value will be brought to account at that time unless
specifically exempted. This is similar to the treatment of trading stock in the existing
law. Under this approach, expenditure will be deductible over the period in which
identifiable benefits are received from the expenditure.

Some transactions either will not be recognised or otherwise will be exempted from
being treated as assets and liabilities (for example, most advertising expenditure). Some
assets and liabilities will be exempted either because the compliance costs involved in
valuation would not warrant their valuation or for specific policy reasons
(Recommendations 4.2 and 4.3). Exemption of certain assets and liabilities from end
of year tax valuation will also provide the mechanism in the law for the calculation of
taxable income under the simplified tax system applying to taxpayers operating small
businesses (see Recommendation 17.1) and for certain other taxpayers
(Recommendations 4.4 and 4.5).

Figure 4.1 depicts the treatment of expenditure under the recommended framework.

Critical features of the cashflow/tax value approach are the tax value rules for assets
and liabilities and the meaning of `asset' and `liability'. As noted, the Review's
recommended approach involves measurement of a taxpayer's income (or return on an
investment) by taking into account changes in the tax value of assets and liabilities over
a year.

The tax value of assets and liabilities on hand at the beginning and end of a year will
be taken into account in the calculation of taxable income.

 Increases in the tax value of assets and reductions in the tax
value of liabilities will add to taxable income.

 Decreases in the tax value of assets and increases in the tax value
of liabilities will reduce taxable income.

Soundly based definitions of `asset' and `liability', and of their associated tax
values in a range of circumstances, are required under this approach. A broad definition
of an asset is required to protect the integrity of the tax base and to ensure that the
tax law remains relevant in the face of asset innovation without the need for continual
adjustment.

 The meaning of `asset' will draw on, and be generally consistent
with, the accounting definition of an asset. There is no general definition of asset in
the existing tax law. An asset is defined for capital gains tax purposes but this
definition is more narrowly focused than the accounting definition. Consistent with the
accounting definition, an asset will be something thatembodies future economic
benefits. Where an asset is held by a taxpayer, the tax value of the asset will generally
be taken into account in the calculation of taxable income - unless it is excluded or
exempt from year-end tax valuation.

 The meaning of `liability' will draw on the accounting definition
of a liability. There is no definition of a liability in the existing tax law. In the new
tax law, a liability will be an obligation that a taxpayer has incurred to provide future
economic benefits. Consistent with the well understood meaning of `incurred' in the
existing law, there must be a present obligation to provide future benefits for there to
be a liability. Some liabilities for accounting purposes, such as provisions for employee
entitlements, will not be recognised as liabilities for taxation purposes, thereby
effectively having a zero tax value (Recommendation 4.21). Where a liability is owed
by a taxpayer, the tax value of the liability will generally be taken into account in
calculating taxable income.

As noted earlier, some transactions will either not be recognised or will be
specifically exempted from being treated as assets or liabilities often through the
assignment of a zero tax value - whether for reasons of compliance cost or policy. In
this regard, the Review emphasises (see Recommendation 4.1(c)) its intention that the
cashflow/tax value approach be implemented in a revenue-neutral manner. Unless other
recommendations in this report expressly propose variations to the existing law, the
presumption should be that identifiable variations to existing policy will not be
implemented by stealth. More generally, the benefits of a more robust and durable tax
system should also be returned to taxpayers via lower tax rates.

Figure 4.1 illustrates that the proposed tax value rules for assets will determine
the timing of the deduction of expenditure in calculating taxable income. An outline of
the tax value of most types of assets is depicted in Figure 4.2.

Figure 4.2 Tax value of assets

Asset type

Assets whose increase in value
is only taxed upon realisation (most assets)

Trading stock

Depreciable assets subject to
write-off at a specified rate for taxation purposes

As can be seen in Figure 4.2, taxpayers will generally not be taxed on unrealised
gains. Gains on most assets will continue to be taxed on a realisation basis. The main
departures from this are the accruals treatment for some financial assets and rights
(Recommendation 9.2) and the market value election available for financial assets
(Recommendation 9.1) or trading stock (Recommendation 4.17).

Critical to the cashflow/tax value approach is the tax value concept. It enables
practical recognition of asset and liability values in the measurement of the components
of a taxpayer's income.

The Review recognises that the proposed approach will impose some transitional costs on
taxpayers and their advisors as well as the Australian Taxation Office as a result of the
introduction of new concepts and newly defined terms such as `asset' and `liability'.
These transitional costs can be justified because of the greater simplification,
certainty, transparency and durability of the recommended framework. The new approach to
structure will produce long-term benefits for Australia's tax system, which the Review
believes will far outweigh the shorter-term costs.

Most taxpayers operating small businesses will feel little practical impact from the
new approach because of the Review's recommendations allowing them to opt into the
simplified tax system (STS) described in Recommendation 17.1. Similarly, there will
be little impact on individuals, who will continue to attract a cash basis treatment on
most income and expenditure (Recommendation 4.4).

To determine a taxpayer's taxable income, adjustments will be required to the net
income amount calculated under the recommended treatment of receipts, expenditure and
changes in the tax values of assets and liabilities as explained above. These adjustments
will be for specific policy reasons. For example, exempt income and the deduction for the
extra 25 per cent of research and development expenditure will reduce taxable
income. Examples of amounts which will increase taxable income, by requiring an addition
to the net income amount, are non-deductible expenditures. These include payments of
dividends and income tax, each of which will continue to be non-deductible.

Also, total spending initially having been taken into the calculation, expenditure
relating to exempt income will be added back to increase taxable income by way of a
specific adjustment.

After taking into account these specific policy adjustments and the carry-forward of
unused losses, taxable income will be determined as shown in Figure 4.3.

Figure 4.3 Calculation of taxable income

Under the existing system, the timing of deductibility of expenditure depends on
whether the expenditure is of a capital nature. In accounting terms a capital expense is
essentially a conversion from one asset (for example, cash) to another asset. In other
words, expenditure is of a capital nature when it is used to acquire, create or improve an
asset. The Review believes that reflecting this approach in the structure of the tax
system will reduce uncertainty and remedy the mischaracterisation of some expenses in the
present law.

A key objective of the cashflow/tax value approach is to classify expenditure as
attracting immediate write-off, amortisation or capitalisation by reference to the life of
the benefit acquired from the incurring of the expenditure. This is based on the notion of
whether or not the expenditure gives rise to a recognisable asset on hand at year-end.

In A Platform for Consultation (pages 39-44), the Review discussed two options
for determining taxable income under the framework incorporating changing tax values of
assets and liabilities. One option maintains the existing assessable income and allowable
deductions dichotomy. The other option adopts an approach based on cash flows and changing
tax values of assets and liabilities. Both options are intended to, and would, produce the
same outcome. They would also produce the same outcome that the current system is intended
to do, under the same policy prescriptions.

The first option would involve the inclusion in assessable income of current receipts
and earnings as well as the increase in the tax value of assets and the reduction in the
tax value of liabilities. Deductions would include current expenditure as well as the
reduction in the tax value of assets and the increase in the tax value of liabilities.

Some tax professionals seem to favour this option because it retains the existing
concepts of assessable income and allowable deductions. However, as assessable income and
expenditure include tax value changes for some assets and liabilities (for example,
debtors and creditors), there would be a need for special rules under this option to
remove the duplications. Removing duplication in the determination of assessable income
and allowable deductions, however, underlines the equivalence between this option and the
second option outlined in A Platform for Consultation.

It is this second option that the Review has concluded should be the approach to be
taken in framing the legislation for the calculation of taxable income. It is based on
cash flows (receipts less payments) and changing tax values of assets and liabilities. The
Review does not see benefit in maintaining the existing terms of `assessable income' and
`allowable deductions'. As noted, those terms would have significantly changed meanings if
they were to be maintained in the new law.

As its primary advantage, this approach delivers structural integrity and durability of
the resulting legislated framework. It is also consistent with the conceptual basis that
has been developed for financial accounting. In addition, by minimising the number of
specific rules required throughout the legislation (a problem that bedevils the current
legislation), it will reduce the volume of tax legislation significantly as well as its
complexity, thereby delivering lower compliance costs. The structural unification
recommended will also provide a basis for ongoing simplification of the tax law.

Calculating taxable income will be conceptually consistent with accounting and economic
approaches to income measurement - although, importantly, tax values will often be
different, and less dependent on legal concepts, from values in the financial balance
sheet because they will be derived from the treatment incorporated in the tax law. In
particular, because realisation is adopted as the basis for taxing gains for most asset
categories and because expenditures will usually be recognised when incurred rather than
when provided for in accounts, tax values will differ from financial balance sheet values.
For example, depreciable assets will be included at tax written down value and most
provisions, such as employee entitlements, will have a nil tax value. As noted, including
depreciable assets at tax written down values and most other assets and liabilities at
cost ensures that related gains are only brought to account on realisation.

The recommended approach is not a revolutionary way of calculating taxable income that
departs from all established processes. It does not result in radically different
outcomes, such as bringing to tax unrealised gains. Substantively, the same calculations
need to be made under the existing law and the proposed approach.

It has been suggested by some that changing from the current system of taxation to the
recommended approach will add substantially to compliance costs and require major
modifications to existing computer systems currently used to calculate taxable income.
This is not the case.

Adoption of the cashflow/tax value approach will not, of itself, require taxpayers to
change the way they currently calculate their taxable income and they can continue to use
their current computer programs. Attachment A demonstrates how the approach can be
applied in practice. Modifications to existing systems will, of course, be required to
reflect policy changes resulting from the implementation of reform measures by the
Parliament. This would be the case whichever legislative structure were to be adopted.

That classes of assets and liabilities not be recognised, or be exempted
from the general requirement for year-end tax valuation (effectively receiving a zero tax
value) if:

(i) it would be unreasonably costly -- relative to the likely
effect on tax assessments -- to ascribe a tax value to the asset or liability; or

(ii) specifically identified policy reasons require such exemption.

In Chapter 3 of A Platform for Consultation,the Review identified a
range of business assets that taxpayers currently do not need to bring to account at
year-end, even though their cost is generally immediately deductible. The range was not
exhaustive. In the absence of specific exemptions, taxpayers would need to bring such
assets to account under the cashflow/tax value approach for determining taxable income.

In principle, the year-end tax value of business assets and liabilities of taxpayers
would be brought to account. Nevertheless, the Review considers that a balance needs to be
struck between that principle and the compliance costs related to that recognition. There
may also be particular policy reasons for not requiring certain assets and liabilities to
be brought to account at year-end for tax purposes.

In selecting those assets and liabilities recommended for exemption, the Review has
balanced the following factors:

 the need to protect the integrity of the law -- exceptions can
create opportunities for manipulation and can lead to disputation about the precise
meaning of the exception;

 the cost to taxpayers of recording the tax value of assets --
some assets can be difficult to value (for example, professional work in progress) and the
inclusion of the tax values of some other assets and liabilities would have little or no
impact on taxpayers' tax liabilities (for example, the net value of the assets and
liabilities associated with a 20 year lease over property subject to regular
commercial lease rentals); and

 the degree of distortion (or impact on revenue) -- some of the
identified assets are usually realised within 12 months and so exemption under the current
treatment is not particularly distortionary.

Simply exempting all short-term assets from being brought to account at year-end would
not be appropriate. A rule as broad as that would cover assets such as trade debts and
trading stock. Those assets often represent a significant portion of the assets of a
business and excluding their value from the income tax base would be unacceptable.
Accordingly, the Review has recommended general principles as well as specifying
particular assets for exemption. Beyond the specific exemptions covered here, exclusions
from asset/liability treatment are incorporated within a range of other
recommendations -- for example, in relation to `routine' leases and rights
(recognising, though, that a lease rental paid in one year for benefits in the next
reflects an asset (prepayment) which would be brought to account in the first year and
extinguished in the next).

That, consistent with the exemption principles, taxpayers not be
required to determine tax values for the following types of assets at year-end:

(i) consumable stores and spare parts, whose cost is not already absorbed
in the tax value of other assets, and whose aggregate tax value does not exceed $25,000;

(ii) office supplies, unless trading stock;

(iii) standing crops and timber established by the taxpayer either for
resale or for environmental works on rural land;

(iv) non-billable work in progress of providers of services for a
fee -- such as professionals, tradesmen and building contractors -- where there
is a reasonable expectation that the service will be billed within 12 months of the year
in which the service was performed;

(v) results of exploration and prospecting activities from mining and
quarrying; and

(vi) expenditure on advertising, except that which gives rise to:

 a depreciable asset, or an improvement to a depreciable
asset, used for advertising purposes; or

 an advertising service or product to be provided after the
end of the year (consistent with other prepayments).

Consumable stores and spare parts do not generally constitute trading stock under the
existing law and so currently do not have to be valued at year-end.

The current treatment of consumables and spares is not entirely appropriate. Some
taxpayers carry significant levels of such assets and deductions ought be allowed only as
they are consumed. On the other hand, it would not be appropriate to require taxpayers to
account for values below a certain limit.

A reasonable limit would seem to be $25,000. That will ensure that most businesses do
not have to incur unnecessary compliance costs. Even where the $25,000 limit is exceeded,
consumables and spares will not have to be separately accounted for if their cost has been
absorbed in the tax value of other assets, such as in trading stock values.

Taxpayers currently do not have to account for the value of consumables and spares to
be consumed, or used in machines, in a taxpayer's office. Usually, significant sums are
not involved.

Requiring taxpayers to value annually stores of such relatively minor assets would
impose additional compliance costs which cannot be justified in terms of tax law integrity
or design. Accordingly, taxpayers will not be required to value these assets.

Generally, taxpayers currently do not have to determine tax values for standing crops
and timber established by them either for purposes of sale or, broadly, for environmental
works on rural land. Establishment costs and development costs are deductible rather than
added to the year-end tax value of these assets.

The current taxation treatment of short-term crops does not represent a significant
distortion. The crops are harvested in the year following the incurring of the
expenditures. Moreover, requiring their valuation for taxation purposes each year could be
difficult, particularly for small farmers. The Review's principles would exempt these
assets from year-end tax valuation.

Considerably more distortionary, however, is the current treatment of the costs of
establishing and developing standing timber -- because immediate deductions are
granted even though a long-term appreciating asset is created as a result. In principle,
the cost of establishing and developing plantation timber should be capitalised until the
plantation is harvested.

Although that would be the outcome under the cashflow/tax value approach, the resultant
lower after-tax returns would be likely to reduce investment in forestry, with undesirable
environmental consequences. The Review notes that denying immediate deductions for the
establishment costs of plantation timber would be inconsistent with the existing policy of
encouraging planting of trees -- important because of the associated environmental
benefits.

In view of the existing policy, and consistent with the policy-based principle for
exemption, the Review is not recommending a change to the current treatment of allowing
immediate deductions for plantation establishment costs other than to the extent of any
prepayments in accordance with Recommendation 4.4(ii).

The Review notes, nevertheless, that the current treatment has encouraged some
end-of-year tax minimisation schemes. Some of the structural improvements to the law
recommended by the Review should address, for the most part, the aggressive features of
tax minimisation schemes -- see the discussion under Recommendation 4.4.

Under the current law, providers of services for a fee (such as professionals, building
contractors, tradesmen and the like) are not required to value their work in progress at
year end to the extent that they are not entitled to bill for that work. Generally, that
is not particularly distortionary as most service contracts tend to be of a short-term
nature, so the income deferral is short. Indeed, the longer the contract, the more likely
that the contract would be subject to periodic payments.

Work in progress of that nature can be difficult to value and to require taxpayers to
do so could impose considerable compliance costs. However, providing a complete exclusion
for such assets would not be appropriate as it could encourage taxpayers to enter into
long-term arrangements for the provision of services on a deferred payments basis.
Therefore, an exclusion will only apply if the work can reasonably be expected to be
billed within 12 months.

Applying the recommended treatment of expenditure and assets without recognising the
valuation difficulties associated with the results of exploration and prospecting
expenditure would mean that the tax treatment of this expenditure would depend on the
results of the exploration or prospecting activity. Unsuccessful expenditure would be
deductible at the time the activity was abandoned, while successful expenditure would
enter the cost base of the project. That is the accounting approach.

It has been a longstanding feature of the current law to allow an immediate deduction
for exploration and prospecting expenditure. Allowing continuation of immediate
deductibility is justified on the basis that the value of the associated asset cannot be
reliably measured.

Most advertising expenditure is deductible immediately under the current law. The
following are exceptions to that general rule.

 Where the expenditure is for the acquisition of, or improvement to,
an asset used for advertising purposes -- for example, an advertising sign or
hoarding. In such cases, the asset would be depreciable.

 Prepayments of services to be rendered by another person where the
service will not be completed within a period of 13 months. In that case, the
expenditure is deductible over the period of time during which the service is to be
rendered.

In many situations advertising expenditure may provide the dual benefit of enhancing
both immediate sales and the value of future sales or goodwill. In practice, it would be
extremely difficult to determine the extent to which expenditure on advertising that has
been `put to air' results in ongoing benefits beyond the period in which the advertising
occurs.

The Review therefore believes that, consistent with accounting practice, there should
be no attempt to recognise the value of an asset for tax purposes in respect of the
end-benefits flowing from advertising. However, consistent with the treatment of
expenditure and the proposed removal of the 13 months prepayments rule (see
Recommendations 4.1 and 4.6), assets will be recognised where expenditure relates to:

 the cost of a depreciable asset used for the purpose of
advertising, such as an advertising sign; or

 an advertising service or product to be provided or developed, at
least partly, after the end of the year, such as a series of television advertisements.

That individual taxpayers be required to determine tax values for the
following assets and liabilities:

(i) depreciable assets subject to write-off for taxation purposes;

(ii) all assets and liabilities (including prepayments) relating to
participation in a project or arrangement, managed by another person or entity, in which a
number of taxpayers individually participate;

(iii) prepayments where the payment relates to the provision of
services or products over a period:

 exceeding twelve months; or

 ending after the next income year;

(iv) assets in which a gain or loss is taxed on realisation;

(v) financial assets and liabilities that would be taxed on an
accruals basis in accordance with Recommendation 9.2 and that have a term of one year
or more where the rate of return applicable to any effective discount or premium is more
than 1 per cent per annum, compounded annually;

Under the current law, a cash basis of accounting has been applied for income derived
by individuals primarily in receipt of employment-related income and/or ordinary interest
and dividends.

Under the cashflow/tax value approach, the change in tax value of some assets and
liabilities would have to be taken into account by some such individuals unless
specifically excluded. The Review considers that individual taxpayers should continue to
be taxed on a cash basis as a general rule. Some assets and liabilities will be valued for
tax purposes and these are specifically listed.

In the case of prepayments, there will be no requirement to generally value such assets
provided the payment does not relate to the provision of services or products over more
than 12 months and the payment does not relate to a period which ends beyond the next
income year. Typical prepayments which will be covered by this 12 month rule are
annual subscriptions to professional or trade associations and for magazines and journals.
This measure ensures, for example, that payments made in June to cover services over the
following year of income will continue to be deductible in the year of payment.

An exception to the 12-month prepayment rule will apply to advance expenditure incurred
(`prepayments') in respect of participation or investment in arrangements or projects
sometimes referred to as `tax shelter schemes'. The type of arrangements intended to be
covered include those that are the subject of product rulings issued by the Australian
Taxation Office.

These types of arrangements generally involve participants incurring expenditure
towards the end of an income year in respect of services to be provided over the following
year. Income from such arrangements is not usually derived, if at all, for a number of
years. In some cases, expenditure is partly financed by non-recourse loans - which
means the investor is only liable to repay the loan from, and to the extent of, any
proceeds from the sale of the product of the underlying asset.

Broadly speaking, under the current law these prepayments of up to 13 months are
immediately deductible if they are not characterised as capital expenditure and provided
the general anti-avoidance provisions do not apply. The current treatment of immediate
deductibility and delayed income has encouraged some end-of-year tax minimisation schemes.

Under the Review's recommended treatment of expenditure and assets, some expenditure
(including prepaid expenses) in respect of these types of investment arrangements will
give rise to an asset, for example, a grapevine. In such cases, the expenditure will be
included in the tax value of the asset and be written off in accordance with the write-off
rules for the relevant class of asset. Whether expenditure gives rise to an asset on hand
at year-end will depend on the facts in each case. The Review believes that such assets
should be brought to account by individual taxpayers. Similarly, where expenditure such as
management fees relating to these investment arrangements is prepaid, the prepayment
should be allocated over the income years to which the payment relates (Recommendation
4.6).

The exception to the 12 month rule for prepayments relating to these arrangements
or projects will affect the treatment of management fees paid at the end of the income
year for services to be provided in the following year. The write-off of the expenditure
for tax purposes will be allowed in the following year.

Where non-recourse funding results in expenditure on the investment scheme greater than
identifiable project-related costs, such as management fees or development costs, the
excess would appear to relate to an asset reflecting the future benefits from the project.
That asset would not attract up-front deduction. It would fall in value to zero if no
future benefits were, in the event, realised. If, in that event, the associated part of
the non-recourse loan were also forgiven there would be no net tax effect under the
recommended treatment of assets and liabilities (and under the matching arrangements
involving debt forgiveness in Recommendation 6.8).

The structural improvements to the law recommended by the Review -- including the
treatment of prepayments -- should address, for the most part, the key features of
the tax minimisation schemes.

Individuals will not be subject to accruals taxation unless the financial asset or
liability provides significant tax deferral opportunities. These opportunities will exist
where, to take the example of a financial asset that would be taxed on an accruals basis
in accordance with Recommendation 9.2, the asset has a term of one year or more, and
the return applicable to any effective discount is more than 1 per cent
per annum, compounded annually. A similar accrual requirement under the existing tax
law also applies to individuals. It means that, for example, if the annual return is
wholly paid out during the income year, an individual does not have to apply accruals
treatment to a loan.

The expression `effective discount or premium' will cover deferred interest and similar
situations (for example, where the capital is indexed to inflation). Subject to the
1 per cent and one year thresholds, the accruals rule will cover synthetic debt
arrangements (see Recommendation 9.9).

That eligible taxpayers operating small businesses who elect to use the
simplified tax systemin accordance with Recommendation 17.1 be required to
determine tax values for those assets and liabilities as specified in
Recommendation 17.2.

The Review is recommending a simplified optional treatment for taxpayers operating
small businesses. The simplified tax system will involve the exclusion of certain assets
and liabilities from year-end tax valuation (see Recommendation 17.1).

(a) That the existing provision allowing immediate deduction for advance
expenditure relating to the provision of services within 13 months be removed from
1 July 2000.

Apportionment principle

(b) That, for taxpayers on both sides of the transaction, advance
expenditure incurred (`prepayments') be allocated over the income years to which the
expenditure relates.

New 12-month rule for taxpayers accounting on cash bases

(c) That most prepayments of no more than 12 months be brought to
account in the year of payment or receipt for taxpayers calculating taxable income using:

(i) a cash basis treatment (Recommendation 4.4), or

(ii) the simplified tax system (Recommendation 17.2).

Transitional arrangements

(d) That, because of the changes to existing treatment, taxpayers be
allowed to bring the initial tax value of prepayments (currently deducted as in paragraph
(a)) to account evenly over five years - except those prepayments relating to
projects or arrangements referred to at Recommendations 4.4(ii) and 17.2.

(e) That, to prevent exploitation of the transitional arrangement in
paragraph (d), the initial tax value of prepayments to be brought to account over
five years be limited to the lesser of:

(i) the prepayments incurred in the 2000-01 year; or

(ii) 110 per cent of the amount of prepayments incurred in the
1999-2000 year.

Under the existing law an immediate deduction is allowed for advance expenditure
incurred (`prepayments') relating to the provision of services to be rendered within
13 months. This 13 month rule for prepayments allows an inappropriate bringing
forward of annual deductions and is inconsistent with the accounting practice of bringing
prepayments to account as assets at year-end. Because of its tax deferral advantages, the
rule has been used by some taxpayers as a key feature of a number of schemes and
arrangements to avoid tax.

The current treatment of allowing immediate deductibility for prepayments provides
inconsistent treatment between payers and payees. As a general rule, a prepayment is not
included in the income of the taxpayer in receipt of the payment until the services to
which the payment relates have been provided. In other words, income is not derived until
it has been earned.

The Review's recommendation will ensure consistent treatment for both the payments and
receipts. Consistent with accounting, the tax value of prepayments at the end of the year
will be brought to account as an asset in the calculation of taxable income. The tax value
of the services to be provided after the end of the year will be brought to account as a
liability by the taxpayer receiving the prepayment.

In the case of individuals, and small business taxpayers who elect for the simplified
tax system treatment, most prepaid expenses will only be treated as an asset at year-end
if the prepayment relates to the provision of services or products over more than
12 months or extends beyond the end of the next year of income (see
Recommendations 4.4 and 17.2). The existing 13 month rule is not appropriate
because it allows the potential for immediate deductibility for expenses relating to
services to be provided in three income years.

Because of the potentially significant first year revenue impact on some taxpayers in
having to account for prepayments as an asset, the Review is recommending a five year
transitional rule in most cases. This means that taxpayers will be allowed to bring the
tax value of the asset at 30 June 2001 evenly to account over five years.

The Review believes, however, that the five year transitional rule is not
warranted for prepayments in respect of the tax shelter type projects or arrangements
discussed at Recommendation 4.4.

Because of the recommended five year transitional measure combined with the
reduction in the entity rate of taxation to 30 per cent in the 2001-02 year,
some taxpayers might seek to exploit the transitional measure by inflating the amount of
prepayments in the 2000-01 year. To prevent such exploitation and its resulting impact on
revenue, the Review believes a further transitional measure is warranted.

The recommended measure will restrict the tax value of prepayments qualifying to be
spread over five years to no more than an increase of 10 per cent over the
amount of the deductions allowed for prepayments in the 1999-2000 income year.

That, provided the terms of payment are within six months, the tax
value of trade debtors and creditors be the nominal value of the amount to be received or
paid.

Taxpayers will be required to account for the tax value of debtors and creditors at
year-end unless they are calculating taxable income using a cash basis treatment
(Recommendation 4.4) or the simplified tax system (Recommendation 17.2). Terms
of payment are generally within six months and hence the recommendation will ensure
that the current treatment for bringing debts to account will continue in most cases.

The Review has identified some assets with trading stock characteristics that taxpayers
currently do not have to bring to account at year-end even though expenditure in respect
of the asset is deductible when incurred. Those assets can represent a significant part of
the income base of some taxpayers so their current treatment is particularly
distortionary.

Generally, providers of products such as gas and electricity are not entitled to bill
customers until they have established the actual value of the product provided --
that is, until they have read customers' meters. Under the existing law, the value of such
assets (unbilled products) is not taxable until the asset matures into a recoverable debt.
The value of such products, as well as the cost of providing them, is capable of being
accurately estimated. Accounting principles also require that the non-billable portion of
delivered products to be brought to account. In this case, the tax treatment should be
consistent with the accounting treatment.

As noted under Recommendation 4.3, stores of consumables and spare parts are not
generally treated as trading stock under the existing law and so do not have to be brought
to account at year-end. Accounting requires year-end stores of such assets to be brought
to account where amounts are material.

The Review is recommending that taxpayers will not have to account for the year-end
stocks of consumable stores and spare parts where the aggregate tax value does not exceed
$25,000 (Recommendation 4.3). Taxpayers will have to account for those assets where
their aggregate tax value exceeds that limit, unless the cost of the items has already
been absorbed into the tax value of other assets, such as trading stock.

Consistent with Recommendation 4.6(d) relating to prepayments, because of the
potentially significant first year revenue impact on some taxpayers in having to account
for the abovementioned assets, the Review recommends a five year transitional rule. This
means that taxpayers will be allowed to bring the tax value of those assets at
30 June 2001 evenly to account over five years.

Assets or liabilities commencing or ceasing to be
private assets or liabilities

(a) That where a taxpayer continues to hold an asset or owe a liability
after it becomes, or ceases to be, a private asset or liability, that asset or liability
be brought into, or taken out of, the tax base at a tax value determined by its market
value at the time.

Assets commencing or ceasing to be listed assets
for capital gains and loss-quarantining treatment

(b) That a gain or loss on the disposal of an asset, which commences or
ceases to be a listed asset for capital gains and loss-quarantining treatment
(Recommendation 4.10), be apportioned between the period before and after the change
on the basis of a tax value determined by the market value of the asset at the time of the
change.

Private assets held or liabilities owed by individuals will be excluded from the tax
base so that any gain or loss on their disposal will not be taxed
(Recommendation 4.13).

Where a private asset held, or a private liability owed, by a taxpayer becomes a
non-private asset or liability, there is a need to decide the tax value of the asset or
liability at the time of the change. For example, if the tax value of an asset was its
original cost, the resulting gain or loss on the eventual realisation of the asset would
include any accrued gain or loss during the period the asset was held as a private asset.
This is an inappropriate outcome.

Where a non-private asset changes to a private asset and therefore leaves the tax base,
there is a corresponding need to ensure that any gain or loss on the asset to that time is
brought to account.

To ensure the appropriate outcome in both situations, such assets and liabilities will
be treated as entering or leaving the tax base at a tax value determined by their market
value at the time of the change. This will provide a means of crystallising any gain or
loss attributable to the private or non-private periods.

In some situations, non-private assets can commence or cease to be listed assets for
capital gains and loss-quarantining purposes while continuing to be held by the same
taxpayer. For example, where held by an individual or superannuation fund, land will be a
capital gains asset unless it is trading stock (Recommendation 4.10).

Situations could arise where land is initially acquired for investment or other
business purposes but converts to trading stock. For example, a taxpayer might acquire
rural land for market-gardening purposes. As a result of urban growth, the taxpayer
decides some years later that it would be more economic to put the land to residential
use. Rather than simply selling the land for the best price, the taxpayer decides to
develop the land into residential allotments and market the individual allotments. In that
instance, the land is likely to become trading stock at the time of the decision to
proceed with the development.

Correspondingly, land could be initially acquired as trading stock and subsequently
converted into long-term investment. For example, a taxpayer could acquire land for the
development of apartment buildings for re-sale. At that point, the land would be trading
stock. Upon completion, the taxpayer decides to keep some or all of the apartments for
long-term investment. At that time, the asset would no longer be trading stock.

Given the different treatment to be applied to listed capital gains assets compared
with other assets -- particularly where held by individuals and superannuation
funds -- capital gains and loss-quarantining treatment ought to apply to so much of
the gain or loss in the above situations that is referable to the period that the assets
are held as listed capital gains assets. In the case of entities, a change in character of
an asset will only have an impact for loss quarantining purposes.

The correct outcome can be achieved by requiring taxpayers to value the asset at the
time of change in its character, so identifying the unrealised gain or loss at the time
(to be brought to account at the time of ultimate disposal). In the case where an asset
converts from a long-term investment asset to trading stock, for example, the asset will
be treated as having a tax value equal to that market value for the purposes of
determining the capital gain or loss referable to the period that the asset was held as a
listed asset.

The recommended treatment differs from that under the current law. A taxpayer holding
an asset that changes its character to trading stock is treated as disposing of the asset
and immediately re-acquiring it either for its cost or market value, at the taxpayer's
option. The current approach has two major disadvantages:

 it taxes unrealised gains if the taxpayer selects market value and
that exceeds the asset's tax value at the time; and

 it can allow capital losses to be converted into revenue losses if
the market value of the asset is less than its cost and the taxpayer elects to value the
asset at cost.

A taxpayer holding trading stock that changes its character to non-trading stock is
treated as disposing of the asset and immediately re-acquiring it at its cost. That
approach has the disadvantage of converting unrealised revenue gains and losses into
capital gains and losses unless the taxpayer has valued the trading stock at other than
cost.

(i) shares and other membership interests - excluding ordinary
partnerships - other than where held before 1 July 2000 as trading stock or
a revenue asset;

(ii) land and buildings - other than where:

 held as trading stock, or

 the building is subject to the new depreciation regime
(Recommendations 8.12 and 8.13), in which case only the land will qualify;

(iii) goodwill;

(iv) statutory licences, long-term crown leases on land and other rights
which represent a permanent disposal of an underlying asset that would be taxed on a
realisation basis;

(v) collectables and other non-depreciable tangible assets (other than
land):

 acquired for more than $10,000, and

 held at least partly for private use; and

(vi) any other assets prescribed in the Income Tax Regulations.

Assets subject to loss-quarantining treatment

(c) That, subject to paragraph (d) and Recommendation 4.11,

 losses on the assets listed in paragraph (b), and

 capital losses on assets acquired before 1 July 2000,

be offset against gains on assets listed in paragraph (b).

(d) That losses on collectables and other non-depreciable tangible assets
(other than land), held at least partly for private use, be offset only against gains on
like assets.

Simplicity in the law will be served by the use of a common basis for defining assets
which will receive capital gains treatment and for which losses will be quarantined. For
those taxpayers receiving this treatment of gains (Recommendations 18.2 and 18.3), a
common asset pool provides a balance against the ability to defer taxation through
selective realisation of losses.

Significant reform to the existing quarantining provisions is limited by revenue
considerations. The revenue consequences of abolishing quarantining of all capital losses
would be prohibitive, due to both the accumulated value of existing capital losses and the
ongoing incentive to realise assets selectively.

Assets where a change in value is taxed on a realisation basis would account for the
majority of assets held by individuals and a significant proportion of assets held by
superannuation funds. Defining access to capital gains treatment and quarantining of
capital losses in terms of the assets described in the recommendation aligns, broadly,
with the `capital' asset distinction in the existing law. Nevertheless, there would be
some notable differences. In particular, losses on shares and land would be quarantined in
a wider range of circumstances due to the removal of the existing distinction between
`revenue' and `capital' assets.

Given the broad correspondence with existing capital gains assets, the listed asset
classes should also define the pool of capital gains against which existing capital losses
and future losses on existing assets can be applied -- subject to private asset
losses being restricted to gains on like assets (paragraph (d)) and the transitional
measure in Recommendation 4.11.

Trading stock will continue to be excluded from capital gains treatment on the basis
that such treatment would be counter to the objectives of encouraging investment in longer
term capital assets and be inconsistent with the existing concept of taxing income from
trading activities. The inclusion of trading stock assets in loss quarantining would
undermine the integrity of capital loss quarantining.

In the case of shares and other membership interests, there is little conceptual or
practical basis upon which to distinguish assets held for trading or investment purposes.
Such assets are not included in the definition of trading stock, which is restricted to
tangible assets (Recommendation 4.16).

One approach considered by the Review was to have an arbitrary time-based distinction
between trading assets and investment assets. Allowing taxpayers the opportunity to
realise losses on shares held for up to 12 months (after which time gains by certain
taxpayers are subject to capital gains treatment) and not quarantining those losses would
be likely to impose a significant cost to revenue. Even allowing a shorter period for loss
quarantining purposes would provide adverse selection opportunities resulting in too great
a revenue cost.

As a general rule, rights will be excluded from capital gains treatment, unless the
granting of a right results in the permanent disposal of an underlying asset, or part of
an underlying asset, that is eligible for such treatment. Capital gains treatment of
rights would only apply where there is a permanent disposal of the underlying asset that
is subject to the right.

Most depreciable assets would not qualify for capital gains treatment due to the annual
deduction for their change in tax value. However, in the case of buildings not depreciable
under the general depreciation regime for depreciable assets (Recommendations 8.12
and 8.13), both the building and the land would be classified as realisation assets and,
hence, would continue to be subject to capital gains treatment and quarantining of losses.

(a) That where a taxpayer on 30 June 2000 holds shares taxed
as `revenue' assets or trading stock under the existing law, losses on capital gains tax
assets acquired before 1 July 2000 not be applied against:

(i) gains on such shares acquired before 1 July 2000; and

(ii) gains on shares acquired on or after 1 July 2000.

Transitional provision for unusable losses

(b) That if a taxpayer has not been able to absorb losses on capital
gains tax assets affected by paragraph (a) by 30 June 2005, up to
20 per cent of those losses be allowed to be offset against gains on shares in
any one year.

At present some taxpayers have realised capital losses which have not been absorbed.
Where those taxpayers also have revenue assets such as shares, those capital losses cannot
be applied against gains on the revenue assets. The proposed removal of the `revenue'
asset/`capital' asset distinction would allow those capital losses to be applied against
gains on revenue assets. Any currently unrealised capital losses could also be applied
when realised against revenue gains.

While the short term revenue impact of allowing the application of capital losses
against revenue asset gains is difficult to measure precisely, it could be significant.
The two main types of assets that are of relevance in this regard are shares and real
estate. Of these, the principal source of potential revenue loss is likely to be from
shares. The Review is therefore recommending that capital losses on assets acquired before
1 July 2000 will not be able to be offset against gains from existing shares
held as revenue assets or trading stock and shares acquired on or after 1 July 2000. This
recommendation will only apply to those taxpayers which have shares taxed as revenue
assets or trading stock under the existing law.

If capital losses are prevented from being absorbed solely because of this
recommendation, up to 20 per cent of those losses will be able to be utilised
against gains on shares in any one year commencing from the 2005-06 year. For
example, this transitional provision would apply if a taxpayer did not have capital gains
assets other than shares.

Relatively few taxpayers are expected to be affected by this recommendation. The main
impact would be on a few large companies. Further, the restrictions imposed under this
measure are not likely to have a significant adverse impact on taxpayers relative to their
treatment under the existing law.

(a) That the application of the concept of private receipts and
expenditures be restricted to individuals on the proviso that benefits provided by
entities to members and employees are either:

(i) generally included in the taxable income of individual recipients as
distributions (Recommendation 12.1); or

(ii) generally subject to fringe benefits tax (or also treated as the
recipient's income if Recommendation 5.1 is adopted).

Specific exceptions

(b) That specific exceptions apply in respect of:

(i) shareholder discounts (Recommendation 12.2); and

(ii) distributions related to personal assets held in entities
(Recommendations 12.25 and 12.26).

An important design issue for business taxation is the business/private dividing line
defined by the treatment of private receipts, expenses and assets. This dividing line was
given only preliminary attention in A Platform for Consultation.

Private receipts and expenditures in concept apply to individuals only and not
entities. Restricting private receipts and expenditures to individuals will mean that all
expenditure undertaken by entities will reduce taxable income either immediately or in
future years unless precluded by a specific adjustment in the tax law.

In order to achieve the correct treatment of expenditure by entities, benefits provided
by entities to employees or members should be taxed as income received at fair market
value. Hence, the broad definition of a distribution from an entity contained in
Recommendation 12.1 and maintenance of comprehensive fringe benefits taxation --
or its replacement as recommended by the Review (see Recommendation 5.1) -- are
crucial to the proposed restriction of private expenditures to individuals.

Under the cashflow/tax value approach, the resulting treatment of expenditure broadens
the scope of expenses that could reduce taxable income. Specifically, it is intended to
allow a wide range of blackhole expenses to be deductible as a matter of principle.
However, individuals' expenditure which is essentially of a private nature will continue
to be non-deductible. To avoid any doubt, the new law will ensure that particular expenses
(such as normal travel to and from work and certain self education expenses) will continue
to be treated as private expenditure.

There will be some inconsistencies in the treatment of benefits received by employees
and members of entities. For example, largely for compliance cost reasons, benefits
received in the form of employer provided car parking (Recommendation 5.3) and the
use of a residence held by an entity (where the related expenses are not deducted --
Recommendations 12.25 and 12.26) will not be taxed in the individual's hands.

(i) the non-monetary income and any private receipts which reflect the
private use of an asset; and

(ii) the corresponding proportion of expenses incurred in relation to the
private use of the asset.

Depreciable assets

(b) That expenses (including depreciation and interest) incurred in
respect of depreciable assets (other than collectables) be apportioned on the basis of
private and non-private usage in the year incurred - with that part relating to
private use not taken into account in calculating taxable income.

(c) That the balancing charge on disposal of a depreciable asset be
apportioned on the basis of overall use of the asset - with that part relating to
private use not taken into account in calculating taxable income.

Land and buildings (other than a taxpayer's main residence)
held by an individual

(d) That, in respect of land and buildings, other than a taxpayer's main
residence, held by an individual and acquired after 30 June 2000, the following
treatment apply:

(i) include expenditure directly attributable to the land in the tax
value of the land to the extent that the land is not used for income-producing purposes
(other than the realisation of a capital gain);

(ii) apply the depreciable assets treatment in paragraphs (b)
and (c) to any structures on the land; and

(iii) apportion interest expenses between the land and structures in
accordance with the acquisition values of the land and structures.

(e) That, in respect of land and buildings held by an individual at
30 June 2000, the existing tax treatment continue to apply.

Collectables and other non-depreciable tangible assets
(other than land) held by an individual at least partly for private use

(f) That, in respect of any collectable and other non-depreciable
tangible asset (other than land) held by an individual, and including any such asset
acquired before 1 July 2000, the following treatment apply:

(i) include in the calculation of taxable income, expenditure incurred in a
year up to the extent of any income -- excluding a gain on disposal of the
asset -- derived in that year from the asset;

(ii) exclude from taxable income any gain or loss if the asset was acquired
for $10,000 or less; and

(iii) quarantine losses on any asset acquired for more than $10,000 to
gains on like assets (Recommendation 4.10(d)).

Assets can generate three types of income - capital gains, current income and
non-monetary income, the latter component reflecting the market value of benefits derived
from the private use of an asset. Both the current income and capital gains represent part
of the monetary income of the asset. There is a compelling case - based on revenue
and compliance grounds - for excluding from the tax base the non-monetary income (and
any private receipts) that reflects the private use of an asset and the corresponding
proportion of expenses incurred in relation to that use.

Difficulties in determining the annual value of the capital gain and non-monetary
components of income for many assets preclude a single practical rule for apportioning
expenses between the private and non-private use of an asset. Hence, different approaches
are required to apportion expenses associated with different types of assets where they
are held at least partly for private use.

Assets held for private purposes are taxed in a variety of ways under the present law,
in terms of the treatment of both expenses and capital gains and losses. Assets held
primarily for private purposes are taxed under different provisions from those held only
partly for private purposes. The approach recommended by the Review will achieve a more
consistent treatment of assets used for private purposes while replicating the existing
treatment to a substantial extent.

Assets, other than a taxpayer's main residence, that are used for private purposes
receive one of three separate tax treatments under the current law.

 Personal use assets -- items other than land and buildings or
collectables held primarily for the private use and enjoyment of the
taxpayer -- are subject to capital gains tax if their purchase value exceeds $10,000.
There is no allowance for capital losses or expenses.

 Collectables -- items such as artworks, antiques and
collections -- are subject to capital gains tax if their purchase value exceeds $500.
Capital losses on collectables are quarantined to capital gains on collectables and there
is no allowance for expenses related to those assets.

 Other assets held for private use, such as land and buildings, and
other assets not held primarily for private use, are subject to capital gains tax
and losses are treated as ordinary capital losses. If those assets were acquired after
20 August 1991, recurrent costs (including interest expenses) are capitalised
into the cost base of the asset -- or deducted as incurred against any recurrent
income generated by the asset. Such costs cannot give rise to a capital loss.

A capital gain or loss in respect of an individual's main residence is generally
ignored for tax purposes under the current law.

Under the proposed approach, the concept of a `personal use asset' and the
discontinuities between the treatment of assets used partly or primarily for private
purposes will be removed. Broadly, an asset other than land will be a private asset if the
asset is held and used by an individual solely for private or domestic purposes and,
except if the asset is a depreciable asset that is not also a collectable, its cost is not
more than $10,000.

Depreciable assets will be treated in a manner similar to the present treatment.
Expenses and that part of the balancing adjustment relating to the private use of the
asset will be excluded from the calculation of taxable income. The exclusion of expenses
and any loss in value associated with the private use of a depreciable asset reflects the
fact that the benefit derived from those costs is not taxed.

For land and buildings acquired after 30 June 2000, the recommended approach
requires for tax purposes the separation of the land from any structures. The required
information will be available for structures commenced to be constructed after
30 June 2000, as a consequence of the proposed separation of land and buildings
for the purposes of a sounder treatment of building depreciation
(Recommendation 8.12).

The treatment for land will be similar to that which currently applies, with directly
attributable expenditures (including interest and rates) being added to the tax value of
the asset to the extent that the land is not used for income producing purposes (other
than a capital gain on realisation). One difference will be that expenses included in the
tax value of land could give rise to a loss on disposal, whereas at present such costs can
be used only to offset a gain.

Expenses associated with structures attached to the land will be apportioned on the
basis of the private and non-private usage of those assets, as for other depreciable
assets used partially for private purposes. This differs from the present treatment where
all non-capital costs of ownership for land and buildings are included in the cost base of
the combined asset. Costs attributable to the building will not be capitalised except for
the capital costs of acquisition and improvement. This approach is consistent with the
treatment for other depreciable assets. The changed approach will apply only to buildings
acquired or constructed after 30 June 2000.

As an example, in the case of a residential property used one-third of the time for
private purposes and two-thirds of the time for income producing purposes:

 two-thirds of the annual expenses attributable to the land (such as
interest and rates) will be deducted in calculating taxable income in each year and
one-third will be added to the tax value of the land; and

 two-thirds of the annual expenses associated with the building and
use of the land (such as maintenance, variable costs and overheads) will be deducted with
the remaining one-third not taken into account in calculating taxable income or the tax
value of the building or land.

Recommendation 4.13(f) will result in one regime for collectables and other
non-depreciable assets held for private use. There will be only one threshold acquisition
amount for capital gains treatment.

Collectables and other non-depreciable assets on hand on 1 July 2000 will be covered by
the new regime. Therefore, existing collectables acquired for more than $500 but no more
than $10,000 will no longer be subject to capital gains treatment when realised.

The treatment for collectables held by an individual (other than as trading stock) and
other non-depreciable tangible assets held by an individual (other than land) will be
different from the present treatment in several respects. For collectables, the main
difference is that the threshold acquisition value for capital gains taxation will be
increased from $500 under the present law to $10,000. For other non-depreciable assets
(apart from land), the main difference lies in having a single treatment for assets used
at least partly for private purposes, rather than a separate treatment for assets used
partly for private purposes and those used primarily for private purposes.

Limiting deductibility of annual expenses to the extent of recurrent income earned from
the asset in the same year, though somewhat arbitrary, provides an objective test upon
which to base the apportionment of expenses.

Recognising that losses on collectables and other non-depreciable assets held by
individuals partly for private use could reflect, in part, the private use of the asset,
losses on those assets will be quarantined to gains on like assets. Collectables held by
an individual as trading stock will be excluded from this treatment.

(a) That blackhole expenditures under the current law be either
expensed, amortised or capitalised where incurred after 30 June 2000.

(b) That, consistent with this principle, write-off be provided for
assets such as lease premiums, franchise fees and the cost of acquiring indefeasible
rights of use (see Section 10).

Statutory deeming of economic life

(c) That expenditure giving rise to assets of indeterminate, but finite,
lives:

(i) be accorded statutory write-off over a period to be determined
on a case-by-case basis; and

(ii) be prescribed in the Income Tax Regulations as eligible for
that statutory write-off.

(d) That the costs of establishing an entity and all forms of capital
raising expenses be prescribed according to paragraph (c) with a 5-year write-off
period and a maximum 5-year write-off period, respectively.

A range of expenditures (blackhole expenditures) is treated inappropriately under
current tax law in that the expenditures are either not deductible or not deductible in a
manner consistent with their economic characteristics (see A Platform for
Consultation at pages 100-102).

Under the cashflow/tax value approach to determining taxable income, blackhole
expenditures will be treated in a manner consistent with their economic characteristics.
Specifically, such expenditure will be either expensed, amortised or capitalised.

 If the expenditure does not form part of the tax value of an asset
or does not reduce a liability, it will, in effect, be immediately deductible.

 Some blackhole expenditures will have the effect of improving a
non-depreciable asset, in which case the expenditure will be added to the tax value of the
asset. The tax effect would be to reduce the taxable gain (or increase the allowable loss)
when the asset is disposed of.

 If the expenditure is related to a depreciable asset, the existing
blackhole expenditure will be written off by reference to the effective life of the asset.
In other cases, while the asset arising from the expenditure is a wasting asset ultimately
having no value, it may not be obviously related to other assets of the taxpayer that are
recognised for tax purposes. Statutory write-off is relevant in these cases.

A range of blackhole expenditures do not have an enduring value or the enduring value
cannot be reasonably estimated. Under the cashflow/tax value approach, such expenditures
will be immediately deductible. Whether an item of expenditure fits within this category
would depend on the particular facts and circumstances.

The following are examples of blackhole expenditure that generally will be immediately
deductible because they would not form part of the tax value of an asset:

 costs of defending title to an asset (including native title
claims) where claims over the title are lodged while the person owns the property;

 costs of defending a takeover, whether successful or not;

 costs of winding-up or closing a business;

 expenditures that contribute to the creation of business goodwill,
such as business relocation costs and market development costs unless the expenditures
give rise to, or improve, a recognisable asset;

 costs of an unsuccessful takeover (deductible at the time of
abandonment of the action) such as the costs of preparing takeover documents to obtain a
strategic stake in a target company (but not the costs of shares acquired and associated
expenses); and

 costs of demolishing an asset which has been held by the taxpayer
for the purposes of producing income other than a capital gain on the associated property.

Some blackhole expenditure has the effect of improving a non-depreciable asset, in
which case the expenditure will be added to the tax value of the asset. In such cases, the
tax effect would be to reduce the taxable gain (or increase the allowable loss) when the
asset is disposed of. Expenditures falling into this category include:

 costs of demolition that have the effect of improving the
underlying property beyond its condition at the time it was acquired;

 costs of landscaping and other earthworks to be maintained on an
indefinite basis;

 costs of defending title to an asset (including native title) if
the asset was acquired with the knowledge that the title, or other rights over the asset,
were in dispute -- otherwise this expenditure would be immediately deductible.

The write-off arrangements for a range of other expenditures that might be considered
to be blackhole expenditures are covered in the proposed treatment of leases and rights.
These expenditures include lease premiums, franchise fees and the cost of acquiring
indefeasible rights of use.

Some expenditures give rise to an asset which will cease to have value at some time but
whose life is indeterminate and do not obviously relate to other relevant assets of the
taxpayer that are recognised for tax purposes. Examples of such assets include business
start-up costs, such as:

 costs of establishing an entity, including company
pre-incorporation expenses such as legal expenses and statutory charges; and

 costs of raising equity and borrowings for an indefinite period
(for example, prospectus and underwriting costs).

Under the existing law, the costs of borrowing are eligible for write-off over the
lesser of five years or the duration of the borrowing. In contrast, the costs of equity
raising are blackholeexpenditures, despite the similarities of a borrowing to an
equity raising. For example, a business can choose to raise additional capital either
through a perpetual floating rate note or new equity. There is thus a strong case for
applying the same taxation treatment to all forms of capital raising expenses.

The existing law treatment of a maximum 5-year statutory write-off for the borrowing
costs would be an appropriate basis to write off the costs of raising equity.

Pre-incorporation expenses have similar attributes to capital raisings as they can be
necessary prerequisites for commencing a business. The Review considers that these
expenses should be accorded a 5-year statutory write-off.

The Review may not have identified all expenditures for which the statutory write-off
would be appropriate. The recommendation to include other expenditures (and their
write-off period) under the Income Tax Regulations, as they are identified, will
facilitate the future operation of the law.

In some cases, it is not evident at the time of incurring expenditure whether or not it
will produce either an asset, or an improvement to an asset - for example, a
feasibility, environmental impact or market study. If the study is abandoned, there would
be no asset and its cost will become deductible at that time. If the project proceeds, the
expenditure will be included in the tax value of the assets associated with the project.

(a) That interest expenditure be viewed as the cost of maintaining
access to the capital funds underlying a business and hence be deductible in calculating
taxable income in the year incurred except:

(i) when incurred as a private or domestic expense;

(ii) when incurred to earn exempt income -- other than exempt
foreign source income (see Recommendations 22.5 and 22.6);

(iii) when the interest is prepaid (see Recommendation 4.6); or

(iv) in respect of borrowings relating to land which is held by an
individual but not used for income-producing purposes (other than the realisation of a
capital gain) - see Recommendation 4.13(d).

Payment of tax liability

(b) That interest in respect of borrowings to fund the payment of tax
liabilities not be treated as a private expense.

The treatment of interest expenses under the current law differs depending upon whether
the expense is incurred:

 before an income earning activity;

 in connection with the earning of capital gains; or

 as part of the process of earning recurrent income.

In practice, these principles of deductibility are difficult to apply consistently due
to the fungible nature of debt. This results in uncertainty and increased compliance
costs, such as in seeking rulings to clarify the treatment of interest in relation to
major investment projects.

The recommended treatment will significantly reduce the current uncertainty surrounding
interest deductibility. It will also result in more equitable treatment for taxpayers.

As noted in A Platform for Consultation (page 44), interest should not be
viewed simply as a cost of earning recurrent income. It is better viewed as the cost of
maintaining access to the capital funds underlying a business. The financial liability
base of a business can be viewed similarly to, but separately from, the real asset base of
a taxpayer. Given that interest expenditure does not directly change the value of the
asset base of the taxpayer, it is appropriately deductible in the year incurred --
other than to the extent to which the interest is prepaid thereby resulting in an asset on
hand at the end of a year.

Interest in respect of borrowings by entities to finance distributions of equity and
dividends, or to finance tax liabilities, will not be private expenditure
(Recommendation 4.12) and will therefore reduce taxable income in the year incurred.
This measure will remove the need to identify the purpose and use of any borrowings by an
entity, other than in connection with the earning of exempt income. In practice, many
business taxpayers are currently able to arrange their affairs to ensure immediate
deductibility of interest on borrowings essentially used to pay tax.

General deductibility for interest will not extend to borrowings by individuals against
assets where the purpose or use of those borrowings is to finance private expenditure. In
other words, the existing purpose or use tests will continue to apply for individuals.

The current treatment of interest on borrowings in respect of land held by individuals
for private use - capitalisation of interest expenses - is also to continue
(Recommendation 4.13(d)).

In the international arena, conditional on the Review's thin capitalisation proposals
in relation to Australian multinational investors (Recommendation 22.6), interest
deductibility will no longer be denied for interest expenses incurred in earning foreign
source income.

To maintain equity with the treatment for entities, it is appropriate that interest in
respect of borrowings undertaken by individuals to meet their tax liabilities not be
treated as a private expense. In practice, most individual taxpayers do not need to borrow
to pay tax liabilities because tax is generally deducted at source.

(i) any tangible asset (or an interest in a tangible asset as a joint
owner) which:

 is produced, manufactured or acquired, and

 is held for the purposes of manufacture, sale or exchange
in the ordinary course of a business; or

(ii) livestock.

The possibility of removing the current arbitrary and uncertain differentiation between
trading stock, `revenue' assets and `capital' assets was canvassed in the Overview of A
Platform for Consultation (page 42). Options for valuing trading stock were canvassed
in Chapter 3 of A Platform for Consultation.

The cost of purchasing or manufacturing trading stock during a year reduces taxable
income -- and the tax value of any of this trading stock held at the end of the year
adds to taxable income. This treatment of expenditure on trading stock is the same in
practice as that proposed under the cashflow/tax value approach. As such, the retention of
the existing concept of trading stock is not required simply for the purposes of applying
that approach.

Where the concept of trading stock, nevertheless, remains relevant is in defining the
manner in which assets that are held by a business for trading purposes should be taxed.
In particular, consistent with the treatment under existing law, gains on disposal of
trading stock assets should not be eligible for capital gains tax treatment while losses
on such assets should not be subject to quarantining (see Recommendation 4.10). Capital
gains tax treatment is aimed at encouraging investment while quarantining of losses is
designed to limit the consequences of selective realisation of capital gains and losses.
Neither of these aspects of the treatment of capital gains and losses is relevant to
trading stock assets.

As against the definition of trading stock in the current law, the proposed definition:

 excludes intangible assets, such as shares and other financial
assets; and

 includes interests in trading stock, such as those held by joint
venturers and partners.

In the case of financial assets, it is both conceptually and practically difficult to
distinguish between individual items on the basis of whether they are held for trading or
investment purposes - hence, the recommended targeting of the trading stock
definition to tangible assets. Financial services entities often account for their trading
activities on a mark-to-market basis and their investment activities on an accruals or
realisation basis. The proposed elective market value regime for tax purposes
(Recommendation 9.1) will allow financial services entities to achieve a match
between tax and accounting treatment.

Interests in trading stock of members of unincorporated joint ventures and ordinary
partnerships will also be treated as trading stock. Under Recommendation 16.16, a
fractional interest approach to computing taxable income will apply to such structures
unless the members elect to apply a joint approach. Under the fractional interest
approach, members will account separately for their interests in trading stock.

Trading stock will also include land (including land held under a long term or
perpetual lease granted by the Crown) currently defined as trading stock and livestock
held for the purpose of primary production.

(a) That, subject to paragraph (b), trading stock be valued at the
lower of cost or net realisable value.

(b) That a taxpayer have the option to make a generally irrevocable
election, at any time on or after 1 July 2000, to value classes of trading stock assets at
market selling value.

Asset classes

(c) That a taxpayer be able to define for tax purposes classes of
trading stock assets on the basis of type of asset but not:

(i) the purpose for which an asset is held;

(ii) time; or

(iii) characteristics that might change while an asset is held.

Variation of election

(d) That if a taxpayer can satisfy the Commissioner of Taxation that a
material change in commercial circumstances justifies a variation of the market valuation
method elected under paragraph (b), the taxpayer be able to vary the election.

Taxpayers can currently elect to value each item of trading stock on one of several
bases at the end of each year. The method of valuation can change from year to year for an
individual item of stock, subject to the requirement that the opening value for an item is
equal to its previous closing value. As discussed in A Platform for Consultation
(page 127), this degree of flexibility provides the scope for taxpayers to manipulate
the valuation of trading stock for tax minimisation purposes. Nevertheless, some
flexibility in the valuation of trading stock is warranted where such assets would
typically be expected to decline in value due to obsolescence or deterioration or where
the use of cost would impose undue compliance costs on the taxpayer.

For trading stock the default valuation option will be the lower of cost or net
realisable value, the accounting method of valuing inventories. This will allow for
reductions in the value of trading stock assets due to obsolescence or deterioration.

The concept of net realisable value is the same as for accounting (Accounting Standard
AASB 1019 `Inventories'). Broadly, it means the estimated proceeds of sale net of all
further costs of completion (where applicable) and costs of selling.

Apart from the default treatment, taxpayers will also continue to have the option of
valuing trading stock at market selling value.

Elective valuation on the basis of asset class allows flexibility yet limits the
potential cost to revenue associated with selective valuation of assets on a
transaction-by-transaction basis or on an annual basis. To achieve this, once an asset
class is defined and a method of valuation other than the lower of cost or net realisable
value elected, all such trading stock assets in that class held by a taxpayer will be
required to be valued using the elected market valuation.

Taxpayers will be able to specify their own asset classes, subject to some
restrictions. This approach will provide flexibility to taxpayers and avoid obvious
difficulties associated with attempting to define classes of assets in legislation. An
asset class will need to be defined on the basis of readily identifiable characteristics
of the included assets.

It is anticipated that taxpayers will specify trading stock classes on the basis of
assets with similar characteristics, such as shelf-life characteristics; similar market
characteristics (for example, price volatility or prices subject to seasonal influence or
fashion); or similar production characteristics. The purpose for which an asset is held
will not be a suitable basis for specifying an asset class, since it would allow, in
effect, the basis of valuation to be determined at the time of lodging a tax return rather
than at the time of acquisition of an asset.

Characteristics that are time dependent will not be suitable as a basis for identifying
asset classes. For example, identifying asset classes on the basis of the date of
acquisition would allow the basis of valuation to be changed on an annual basis in the
case of frequently traded assets, such as occurs under the existing trading stock
valuation rules. Similarly, it would not be appropriate to allow asset classes to be
defined in respect of characteristics that could change during the period that the asset
is held, as this would allow the basis of valuation of an individual asset to change.

Making the election generally irrevocable reinforces the integrity of its use.
Taxpayers will be inclined to make an election where there are clear ongoing benefits from
doing so. Nevertheless, there is merit in providing some scope to vary an election for a
class of assets where a taxpayer can satisfy the Commissioner of Taxation that a material
change in commercial circumstances warrants a variation of an election.

That, in determining the tax value of assets, `cost' be defined to have
a consistent meaning including all expenditure incurred in bringing an asset to its
present condition and location - such as:

(i) the acquisition price of an asset in an arm's-length
transaction;

(ii) incidental expenditure incurred to acquire the asset;

(iii) expenditure incurred in making an asset ready for use or sale;

(iv) expenditure incurred in the creation of a new asset; and

(v) expenditure incurred in improving an existing asset.

The meaning of cost is an important element of the current law -- for example, to
determine the cost for taxation purposes of depreciable plant and trading stock. Its
meaning will be critical under the cashflow/tax value approach, as cost will be the basis
from which the tax value of most assets will be determined.

Except for capital gains tax (CGT) purposes, the current law is generally silent about
the meaning of cost. However, its meaning is generally well understood and broadly
consistent with accounting practice. The courts have clarified its meaning over time and
have often adopted the accounting concept for determining the meaning of cost for taxation
purposes. As well, the Australian Taxation Office (ATO) has issued guidelines and rulings
on its application.

Under the present law, the cost base of an asset differs depending on the way in which
the asset is characterised.

 The cost of a purchased asset includes not only its acquisition
price but also all expenditures associated with its acquisition and making the asset ready
for use -- for example, stamp duties, commissions and costs of delivery and
installation.

 The cost of manufactured assets, such as trading stock, includes
materials, direct labour and an appropriate share of attributable indirect costs, such as
factory overheads. That method of determining the cost of manufactured assets is known as
(full) absorption costing.

 The cost of an asset also includes expenditure incurred in making
improvements to the asset. For example, the cost of a depreciable asset would include the
cost of extending its life or making it more efficient.

 The meaning of cost for CGT purposes is broadly consistent with the
general understanding of the meaning of cost. Additionally, the cost base includes
expenditure associated with establishing, preserving or defending the taxpayer's title to,
or right over, the asset and, in the case of some personal use assets, costs that would
ordinarily be deductible -- such as interest and repairs.

Consistency and simplicity argue for having a single method of determining the cost of
an asset. The absorption cost principle used in accounting standards as the basis for
valuing inventories includes in the cost of the asset all direct and indirect expenditures
attributable to bringing an asset to its present state and location. Hence, it represents
an appropriate basis upon which to frame a single approach to determining the cost of an
asset.

A key issue in defining a general meaning of cost using the absorption principle is
determining the point at which costs cease to be absorbed into the cost of the asset.
Accounting Standard AASB 1019 includes all costs incurred in bringing the asset to
its present location and condition. From the limited case law available on this issue, the
application of the absorption principle for taxation purposes appears to parallel closely
that applied for accounting purposes. The implication of the accounting approach is that
all costs incurred in bringing an asset to its `final point of sale' would be absorbed
into the cost of the asset.

Another important aspect of determining cost for an asset is the delineation between
expenditures that simply maintain the value of the asset and those that add to the value
of the asset. In principle, expenditure that improves an asset -- for example, by
extending its effective life beyond that assessed at the time it was acquired --
should be added to the tax value of that asset. However, in practice, it is not always
easy to delineate the extent to which expenditure on an asset represents repairs and
maintenance, an improvement to an existing asset or a new asset.

Existing case law provides guidance on when expenditure represents repairs or
maintenance rather than an improvement. The existing treatment does not attempt to
apportion expenditure between that which might represent maintenance and that which might
represent an improvement. Under the proposed treatment of expenditure and assets,
determining whether expenditure represents maintenance or an improvement will remain
necessary.

Expenditures that do not directly or indirectly contribute to the acquisition, creation
or improvement of an asset will not be included in the tax value of the asset. For
example, the following expenditures will not be included as part of the tax value of an
asset on the basis that they are not reflected in a change in the value of the asset to
the taxpayer:

 interest on money borrowed to finance the asset or the taxpayer's
activities more generally (other than for land that is used privately);

(a) That where a taxpayer is using cost for determining tax value and
can identify an individual asset, the taxpayer may use:

(i) actual cost; or

(ii) as a basis of determining the cost of homogeneous assets -

 either the first-in-first-out (FIFO) method, or

 the weighted average method.

Unidentifiable assets not subject to capital gains treatment

(b) That where a taxpayer cannot identify individual assets and the
assets are not subject to capital gains treatment, the taxpayer determine cost by applying
consistently:

(i) either the FIFO method; or

(ii) the weighted average method.

Assets subject to capital gains treatment

(c) That where an asset is subject to capital gains treatment (see
Recommendations 4.10), the weighted average method of determining cost be applied
only to purchases on the same day.

Different methods of determining the cost of an asset are currently allowable for both
accounting and tax purposes. Identifying precisely the cost of each asset on hand at
year-end can be extremely difficult, if not impossible, to do where the taxpayer holds a
number of indistinguishable assets acquired at different costs. ATO administrative
practice has been to allow taxpayers to assign costs under either the FIFO or the weighted
average cost method -- although the weighted average method has limited application
for capital gains tax (CGT) purposes.

 The FIFO approach assumes that the oldest items are disposed of
first. It is a reasonable assumption about the pattern of disposal of many
indistinguishable assets subject to deterioration or obsolescence.

 Weighted average cost allows the cost of items on hand at the
beginning of the year to be averaged with the cost of items acquired during the year.

 For CGT purposes, taxpayers need to know the actual date of
acquisition so weighted average is acceptable only to the extent that it is used to derive
an average cost of homogeneous assets acquired on a particular date for different prices.

The use of different methods for determining cost is generally applicable to trading
stock assets and other assets where a gain is taxed on realisation. For the purposes of
determining the cost of assets under the cashflow/tax value approach, taxpayers will have
the option of identifying assets separately, even though they may be identical, if there
is a reasonable basis upon which to do so. For example, taxpayers could nominate the
specific shares being disposed of where they have a reasonable means of identifying
individual purchases of shares. Nevertheless, some taxpayers might choose to utilise the
FIFO or weighted average methods for homogeneous assets as a means of reducing record
keeping requirements -- such as in the case of trading stock assets. Both the FIFO
and weighted average methods are acceptable alternatives in valuing homogeneous
inventories for accounting purposes. To prevent possible manipulation of taxable income,
taxpayers will be required to use either method consistently for each type of homogeneous
asset. For example, a consistent method must be used for shares in a particular company.

For the purpose of capital gains treatment, it will remain necessary to identify the
date of acquisition of an asset, due to the 12 month holding rule
(Recommendations 18.2 and 18.3). Accordingly, only the FIFO method of identifying
homogeneous assets will normally be acceptable as an alternative to individual
identification where those assets are subject to capital gains treatment. As an exception,
the weighted average method will be allowable in determining the average cost of
homogeneous assets acquired on a particular date for different prices in those
circumstances where it is not possible to apply the FIFO rule to those acquisitions.

That the current option for primary producers to value natural increase
in livestock at statutory rates in lieu of actual cost be retained.

Livestock producers currently have the option of valuing natural increase at statutory
rates in lieu of actual cost -- for example, natural increases in cattle can be
valued at $20 per head. That option will be retained.

provisions be recognised for taxation purposes for the following items:

(i) employee entitlements, such as long service leave;

(ii) retirement of non-executive directors;

(iii) product liability;

(iv) warranties; and

(v) taxes other than income tax.

Provisions are a technique used in accounting to deal with uncertainty about the value
now of future expected cash transactions. The recommendation allows taxpayers to put a tax
value on a recognised liability at the end of a year whenever a reasonable estimate of the
amount can be made.

How the recommendation will be applied in practice may be illustrated for long service
leave and warranties. Similar reasoning applies to the other provisions that will be
allowed. The amounts allowed for taxation purposes will not be the same as those allowed
for accounting purposes. For taxation purposes, a recognised liability must be a present
obligation that has also been incurred. Some amounts that are recognised for accounting
purposes will not be recognised for taxation purposes, and will therefore have a zero tax
value.

Taxpayers will be allowed to recognise a provisional liability for the amount required
to satisfy long service leave payments that have been claimed by employees but not paid
out before the end of the taxation year. Accordingly, no liability will be recognised for
a long service leave obligation that is contingent on an employee submitting a valid
claim, even if previous experience suggests that some existing employees will claim a long
service payment. In contrast, accounting practice allows a provision to be established for
the reasonable estimate of the long service leave that will be paid to existing employees,
even though the leave has not formally been accrued or claimed.

In relation to warranties, a taxpayer may have a warranty obligation in relation to
items sold before the end of the year that are returned for repair or replacement within
the warranty period. The recommendation will allow the taxpayer to recognise a liability
for a reasonable estimate of the amount required to repair or replace the items that have
failed before the end of the year but have not yet been returned for repair or
replacement. The taxpayer might estimate this amount after surveying customers on the time
it takes them to realise that a fault exists and to return the item for repair or
replacement. In contrast, the corresponding accounting provision includes additional
amounts that are contingent on an item being returned faulty before the warranty period
expires, because it is more likely than not that an item will be returned.

The first category arises because the financial statements of some companies include
items described as provisions but which are not liabilities under the proposed taxation
definition. The existence of a present obligation is a necessary element of the definition
of a liability for tax purposes. There is the question whether taxpayers should be able to
establish taxation provisions for self-insurance and plant overhaul. These items do not,
however, involve a present obligation which has been incurred and therefore would not be
recognised as liabilities for taxation purposes.

In the case of self-insurance, there is no present obligation until an insurable event
occurs. If, however, a present obligation arises on the occurrence of an insurable event,
taxpayers will be able to provide for the expected cost of insurable events that occur
during the year.

In the case of plant overhaul, the taxpayer controlling the asset does not have a
present obligation until the plant overhaul has been contracted for or performed. Thus,
there is no present obligation and so no provision is recognised for tax purposes at an
earlier time. The mere intention, necessity or expectation of the need to make a payment
in the future is not sufficient to give rise to a present obligation.

The next category not to be recognised arises because, for taxation purposes, a
liability must be owed to another taxpayer or person. In contrast, for accounting
purposes, a liability may be owed to a group of taxpayers or to the public at large.
Accordingly, accounting will recognise a provision made for a taxpayer's obligation to
make a payment in the public interest. Items in this category that will not be recognised
for taxation purposes include provisions for:

The third category arises because, for taxation purposes, a liability is not permitted
to be conditional on the occurrence of a future event, even if the occurrence of the event
is reasonably certain. Accounting practice allows the provision to be established if the
occurrence of the event is more likely than not. Litigation damages exemplify an
accounting provision that will not be recognised for taxation purposes.

(a) That taxpayers continue to be able to write off a debt to the extent
that it is bad.

Writing off bad debts by financial institutions

(b) That deposit-taking institutions be able to establish for taxation
purposes a provision for bad debts that have already been incurred provided there is an
actuarial basis for the amount.

This recommendation will generally preserve the existing position under the taxation
law in relation to bad debts.

Accordingly, all taxpayers will continue to be able to write off a debt that is bad and
to write off part of a debt where only some of the debt is bad.

The recommendation will also retain the existing capacity for financial institutions
such as banks, credit unions and building societies that are prudentially regulated to
establish a provision for bad debts that have already been incurred and for which there is
an actuarial basis for the calculation.

That appropriate regard be had to accounting principles in the
development of taxation legislation for the Integrated Tax Code.

The Review noted in A Platform for Consultation (pages 45-47) that a
substantial degree of correspondence can be recognised between the conceptual benchmark
for an income tax base and income specified in accounting concepts and standards. For
example, the accounting concepts focus on economic gains and losses regardless of the
legal character they may have under judicial concepts of income.

Despite the correspondence between taxation and accounting concepts at the higher
level, accounting profit cannot be used directly as the measure of taxable income.

Taxation and general purpose financial reporting are intended to serve different
objectives.

Because income taxation is required to raise sufficient revenue to meet the needs of
government it requires less flexibility than general purpose financial reporting presents
in the recognition and measurement of income. Moreover, because taxpayers have an
incentive to manage their taxation obligations strategically, restricting taxpayer choices
in the measurement of income will sometimes be necessary in ways that are not required for
accounting purposes.

In contrast, financial reporting explicitly allows greater subjectivity in the
recognition and measurement of income through the selection of appropriate accounting
policies, provided these are disclosed in the financial statements. The notion of
materiality influences whether an item is required to be recognised for financial
reporting purposes and also the margin of error that is acceptable in the amount
attributed to an item. Materiality is a matter of professional judgment.

In more practical terms, not all taxpayers are required to prepare financial statements
in accordance with accounting standards. In addition, the tax law could also not passively
reflect continual changes in accounting standards in the measurement of taxable income.
Accounting standards in Australia also differ from international standards. Moreover,
accounting rules are insufficiently comprehensive in some areas to be used for taxation
purposes - for example, in relation to financial assets and liabilities.

Nevertheless, the substantial correspondence between tax and accounting income at the
conceptual level means that accounting concepts and standards should be able to assist in
the development of rules specifying taxable income. A consequent greater matching of tax
and accounting requirements should reduce compliance costs for many taxpayers.

The Review has drawn on accounting principles in developing the draft law accompanying
this report. Most importantly, the cashflow/tax value regime draws heavily on accounting
concepts in specifying the boundary lines between immediate write-off, amortisation or
capitalisation of business expenditure. These boundary lines are based on economic
concepts relating to the timing of the future benefits arising from the expenditure --
replacing current inconsistencies and anomalies stemming from the distinction between
recurrent and capital expenditure.

As a further example, the draft legislation for the single regime for depreciable
assets also moves closer to the accounting treatment in many respects. The correspondence
between the proposed consolidation regime for wholly owned groups and accounting standards
should also help to provide early compliance benefits.

Drawing on accounting principle where possible in the development of future income tax
law should see more convergence of accounting and tax treatment over time.

That the Australian Taxation Office work with the accounting and tax
professions to identify differences between the accounting and taxation treatments of
profits with a view to better aligning these treatments where the differences are
inappropriate.

As noted, certain of the Review's proposals will move tax and accounting treatments of
income closer together. This will reduce compliance costs. However, the calculation of
taxable income will not generally be the same as the calculation of profits under the
accounting standards.

Identification and analysis of the differences between the calculation of accounting
profits and taxable income will be of advantage to both taxpayers and tax administration.
These differences will be highlighted and will have to be justified. This has the
potential to move the accounting and taxation systems closer together, further reducing
compliance costs.

This Attachment presents a demonstration case study including five statements
showing how the financial statements, the current calculation of taxable income and the
cashflow/tax value approach interrelate.

Statement 3, entitled `Statement of Taxable Income (working from tax values of assets
and liabilities)', is a format which can be used in one of two ways to generate the same
taxable income. It can be used as:

 the primary method to calculate the taxable income of the taxpaying
entity, or

 a reconciliation statement to verify that the taxable income as
calculated by other approaches is in accord with the proposed tax law.

The only information not currently used by most taxpayers in calculating taxable income
is the gross amount of the receipts and payments for the taxpaying entity. This
information will be readily available for entities that produce cash flow statements. For
those taxpaying entities that are part of a group that only produces a consolidated funds
statement, the consolidation worksheet should usually disclose the receipts and payments
of each subsidiary in arriving at the consolidated totals. For simpler businesses the
total of receipts and payments in the cash account would provide the necessary
information.

Statement 3 provides the information necessary for the reconciliation between the
actual and the prima facie Australian tax payable - as reported by listed
companies when there is greater than a 15 per cent difference between the two amounts.

Following are five statements to illustrate how the financial and taxation statements
interrelate.

The statements, as presented, allow the reader to correlate amounts derived from the
profit and loss and cash flow statements. Not surprisingly the taxable income determined
by both methods of calculation is identical (see Statements 2 and 3).

The statements that follow include balance sheet figures derived up to the stage of
determining profit before tax. This is the point at which taxable income would be
calculated using the Statement 3 method. Statement 3 can also be prepared using final
balance sheet amounts - that is, after determination of net profit, provision for taxation
(current, deferred and/or future tax benefits), provision for dividend, and the retained
earnings balance.

The method used in Statement 3 works equally well at either stage and, naturally, the
amount for taxable income that is calculated at either stage is the same.

If the method is used to reconcile the taxable income to the tax law, it is likely that
the spreadsheet would start from the final balance sheet numbers.

If the Statement 3 method is adopted as the basic method of calculating taxable income,
then naturally the taxpayer will start from profit before tax (as in the illustrative case
study).

The illustrative study starts from profit before tax so that both Statements 2 and 3
are taken to the taxable income stage.

This demonstrates both the technique and the identical results for taxable income.

The progression from the profit and loss statement (in Statement 1) to taxable income
(in Statement 2) is readily discernible. Non-cash charges, such as the provision for
doubtful debts, which are expensed in arriving at profit before tax, but not deductible
for tax, are added back on Statement 2.

Non-deductible expenditures charged against earnings are added back and concessional
amounts deductible for tax are subtracted in arriving at taxable income. These same
adjustments are also required in Statement 3 and are described as `Income Tax Law
Adjustments' in the proposed tax law. They have been shown in boxes in Statements 2 and 3
to highlight the identical treatment required.

The sub-totals on both statements ($6,625,000) before the adjustments are, naturally,
identical. The unifying principle - cash receipts less payments plus/minus changes in
tax values - gives the same result for taxable income before the tax adjustments in the
boxes, under both methods.

The results are identical because of the linkage between the two methods. For example,
sales revenue expressed as sales made during the year comprising those paid for and those
yet to be paid for (that is, debtors) gives the same result as cash receipts for sales
received during the year plus/minus the change in the debtors account.

The method of calculating the tax value of assets and liabilities is referred to in the
notes to Statement 3 and in the detail of Statement 5.

Taxpayers who continue to use their established computer software to calculate taxable
income will have the information to readily complete a spreadsheet, in the format adopted
for Statement 3, in a relatively short time frame. As stated earlier, the only additional
information required is the aggregate receipts and payments for the tax year. It will not
represent an additional significant increase in compliance costs.

The basis of calculation described in this paper will apply generally but the Review is
recommending a simplified tax system approach for small businesses.

The important advantage is that the tax system, itself, will have greater durability
and will be less complex. The resulting reduction in compliance costs should certainly
prove greater than the effort required to produce the equivalent of Statement 3 to
establish that the taxable income calculated by any other method is in accord with the tax
law.

Statement 1

Profit and Loss Statement 1999 ($`000)

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Statement 2

Taxable income - current calculation ($`000)

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Note: Adjustments of the kind shown in the box are the same adjustments required as
shown in the 'Tax Adjustments` column in Statement 3, 'Statement of Taxable Income -
cashflow/tax value approach'.

Statement 3

Statement of taxable income - cashflow/tax value approach ($`000)

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Notes

1 Retained earnings and non-cash additions to reserve accounts have no tax value.

2 Provisions balances have no tax value.

3 Cash balances (positive and negative) have no tax value.

4 The amounts in the box in 'Taxable Income' column are the same adjustments as appear
in the current conventional calculation of taxable income.